Revisiting Banking Union in a Single Currency Area (Part 2)

The current banking union framework remains far from ideal if the currency union dimension is taken into account. While decisions so far have been focusing on the moral hazard of banks, these measures fail to solve an additional market failure in the Euro area caused by the moral hazard of governments competing on funding costs, which puts off a proper management of legacy losses via bank restructuring. Losses on legacy assets can hamper governments’ ability to raise money in a common currency area. Governments may thus delay absorption, so fuelling risk aversion and slowing down economic recovery. Two remedies are required: a common (unlimited) financial backstop to a privately funded recapitalisation/resolution fund and a blanketprohibition of state aids.

Factoring in the single currency dimension: any lesson from Japan?

Bignon et al (2013) have recently showed that ‘home bias’ can lead an imperfect banking union to undermine citizens’ welfare in a currency union, thus threatening the stability of and hence political support for the euro area. As discussed in part 1, capital (savings) flights across Euro area countries may push governments to overreact. As the financial backstop for banks is under national fiscal policy actions, when the financial crisis hit, governments tend to avoid that instability in the banking system would result in capital shifting towards safer banking systems within the same currency area, causing a sharp increase in their funding costs. Government intervention disregards the judgement about the overall stability of the Euro area when deciding to intervene for a bank. Frictions in the banking system have also slowed down the creation of a single market for banks’ control, despite the low market capitalisation that several banks have today.[1] This is mostly due to the uncertainty created by different legal systems and insufficient transparency.

The moral hazard governments incur in putting off to their successors the restructuring of the banking system to avoid repercussions on their borrowing costs resembles what happened in Japan after the incredible growth of its banking sector during the 1970s, when the national economy was still fairly closed. After the country gradually opened up, the delay in restructuring banks and corporations in the country, driven by the interference of public policies, substantially contributed to its stagnation over the years. These tensions depressed the economy by distorting the proper channelling of credit into the economy or diverting it toward underperforming sectors (Hoshi and Kashyap, 2004; 2011). The Japanese experience offers lessons about the importance of a flexible financial system in an open economy, through, for instance, solid resolution procedures that allow restructuring (and liquidation) of banks when they suffer losses caused by a prolonged downturn in the business cycle.

Banking Union Revisited

Banking union in a single currency area, whether within a single state or a community of states, faces three potential market failures: risk-taking behaviours; depositors’ run on banks; and financial disintegration (see Table 1).

While risk-taking behaviours and runs on banks are universal market failures when dealing with the economics of banking and money (Diamond and Dybvig, 1983; Akerlof and Romer, 1993; Stiglitz, 1993), financial disintegration driven by the moral hazard of governments that compete on their own funding is a market failure caused by the common currency framework. In a common financial system, a public (supranational) intervention is needed to ensure that the location of the bank (and not its assets)[2] does not affect its borrowing costs and the funding costs of the government where it is legally headquartered. A banking union for the Euro area would thus require a European resolution mechanism that make the nationality of taxpayers neutral vis-à-vis the credit risk of local banks.

A disorderly European intervention?

Despite the bold actions taken by the European Central Bank to avoid market disruptions and two official reports by the presidents of the ECB, European Council, European Commission and Eurogroup (EU Council, 2012a and b) to lay out reforms for the euro area, European Union institutions’ initiatives in the service of creating a banking union have been mostly characterised as actions to ensure the cohesion of the single market, under the tools offered by the European Union Treaties. (mainly art. 114 TFEU and Meroni case law).

As a consequence, those actions have mostly focused on the first two market failures, which can indeed impair the single market. No much has been done, however, to avoid the delay in legacy losses absorption. In particular, current reforms are ineffective to deal with the moral hazard of governments because they neglect the importance of a credible common resolution/recapitalisation bank-funded fund with a common unlimited backstop and a tout court prohibition of governments’ state aids (recapitalisation, asset relief, guarantees, etc).[3] Under the single market mandate, critical steps toward a banking union, such as a credible common resolution/recapitalisation bank-supplied fund with a common, unlimited backstop and prohibition on state aid, look like an unnecessary corollary to current financial integration. In truth, it is harder to justify these actions under the single market umbrella because national banking systems outside the euro area are indeed marketing services at the EU-wide level, but they are acting in accordance with national monetary policy and a credible (sizeable and funded) backstop that is ultimately in the hands of the domestic government, backed by their own central bank. Keeping the backstop national in this case avoids indirect cession of monetary and fiscal policy sovereignty to EU institutions. An EU undertaking to override this defence of sovereignty via a more comprehensive backstop and supervisory framework at EU level might not be interpreted as a complementary act to national prudential supervision for the smooth functioning of the single market, thus violating the subsidiarity principle enshrined in the Treaty on European Union (TEU).

Conclusion

Although the ECB will soon take over supervision of most of European banks, not much can practically be done today at the European or euro-area level to recapitalise (with strict conditionality in place) or to resolve euro-area banks without the intermediation of national governments and political establishments, which are often deeply involved in the governance of their own banks. To slow down financial disintegration, a credible (funded and sizeable) financial backstop to a privately funded resolution/recapitalisation fund, coupled with a blanket state aidsprohibition, is a fundamental piece to a banking union for a common currency area. The prolonged inability to remove frictions to credit markets may cause unpredictable effects for the stability of the Euro area, as the health of local banks continues to deteriorate.

– (2014), “Framing banking union in a common currency area: some empirical evidence from the Euro area”, Forthcoming CEPS Working Document.

[1] The three top Italian banks (by assets) had a total market capitalisation of €58.8 bn on 16th December 2013.

[2] The quality of the assets will always be affected by the economic conditions of the economy in which they are located. For instance, real estate assets in Spain shall be affected by the asset bubble in the country to the same extent whether the owner is a Spanish or a foreign bank.